Question

Sadie Manufacturing makes fashion products and competes on the basis of quality and​ leading-edge designs. The company has $1,500,000 invested in assets in its clothing manufacturing division.​ After-tax operating income from sales of clothing this year is $450,000.

The cosmetics division has $6,200,000 invested in assets and an​ after-tax operating income this year of $1,550,000. Income for the clothing division has grown steadily over the past few years. The​ weighted-average cost of capital for Sadie is 10​%. The CEO of Sadie has told the manager of each division that the division that​ "performs best" this year will get a bonus.

1.	Calculate the ROI and residual income for each division of Sadie Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each​measure?
2.	The CEO of Sadie Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate EVA adjusted incomes of clothing and​ cosmetics, and finds that the adjusted​ after-tax operating incomes are $255,300 and $710,400​, respectively.​ Also, the clothing division has $390,000 of current​ liabilities, while the cosmetics division has only $280,000 of current liabilities. Using the preceding​ information, calculate​ EVA, and discuss which division manager will get the bonus.
3.	What nonfinancial measures could Sadie use to evaluate divisional​ performances?

Answer 1

1)		Clothing	Cosmetics
	Operating income after tax	450000	1550000
	Net assets	1500000	6200000
	ROI:
	450000/1500000 =	30.00%
	1550000/6200000 =		25.00%
	Residual Income:
	450000-10%*1500000 =	300000
	1550000-6200000*10% =		930000
	The choice of measure chosen to evaluate the mangers, will decide the person
	who will get the bonus.
	If ROI is chosen, the clothing division will get the bonus (as it has highet ROI); if
	residual income is chosen the bonus will go to the cosmetics division.
	The ROI is a comprehensive performance measure that takes into account not only the revenues
	and costs but also the value of invetment that is used to produce the revenues
	and expenses. Further, as it gives the measure as a % return it is easy to
	understand; the calculation is also simple.
	The major disadvantage, of using ROI is that, it will force managers to reject projects that
	have an ROI less than the target ROI, eventhough they have positive NPV. This is against
	the principle of maximisation of shareholders wealth.
	The residual income measure will not reject projects with positive NPVs and hence is
	consistent with the wealth maximisation goal. As a result, firms will not lose projects
	that have positive NPV's.
	The disadvantage of the RI measure is that, being an absolute measure it does
	not consider the size of the investment due to which it cannot be used to compare
	divisions that have sizeable difference in value of investment.
2)	EVA is given by the formula
	EVA = NOPAT-Invested capital*WACC
		Clothing	Cosmetics
	Adjusted after tax operating incomes	255300	710400
	Assets	1500000	6200000
	Less: Current liabilities	390000	280000
	Invested capital	1110000	5920000
	EVA = Adjusted NOPAT-Invested capital*WACC
	255300-1110000*10% =	144300
	710400-5920000*10% =		118400
	Using EVA, the Clothing division will get bonus as it has higher EVA.
3)	Non-financial measures could be:
	*market share
	*customer satisfaction
	*Defect percentge